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derivatives as a way of mitigating financial risk
Finance & Accounting
Pages 8 (2008 words)
Derivatives as a way of mitigating financial risk October 19, 2012 1. Introduction Derivative is a type of financial instrument and a contract drawn between two parties for certain assets that are subject to variables such as value of the assets, dates and notional amounts.
Certain creditor protection rules are extended to these derivatives and this helps to increase their security and reduce financial risks. The other side is that with excessive credit protection norms, capital markets will under price the credit risks. This means that risks that should be valued at say 100 Pounds will be considered to be worth only 80 Pounds. This increases systemic risks and helps to propagate credit booms. The reason is that the lending firm considers a risk of 80 Pounds worthwhile while extending loans whereas if the assets had a risk of 100 Pounds, the lending firm would reduce the amount lent (Chance and Brooks, 2010). The paper will examine how derivatives based on standard assets and bonds can be used as a method of mitigating risk. 1.1. OTC and ETD and risk management Two main types of derivates are available and these are over the counter derivatives – OTC’ and ‘exchange traded derivative contracts’ - ETD. OTC instruments are privately traded between two parties and the exchange is not involved. Instruments traded included forward rate agreements, exotic options, swaps and other types. The main constituents and partners in the OTC markets are banks, financial institutions and hedge funds. The market is estimated to be worth 708 trillion USD and most of it occurs in private without any public listing and declaration. ...
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